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Break out – the big picture

18:05, August 02 2016
· By Michael McCarthy

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Today the RBA board will decide whether to cut rates further. Interest rate futures markets are indicating it’s a 60/40 call in favour of a cut. However, there’s a real possibility the share market index may continue to rise whichever way the RBA goes.

Classical versus behavioural economics

The case for further gains on a rate cut is economic orthodoxy. Lower interest rates mean lower business costs. It also means investors earn less on their deposits, making shares relatively more attractive. And lower interest rates can drag the AUD lower, making Australian shares more attractive to international investors. All of these factors should be supportive of share prices. So far, so good.

While these ideas are sound in theory, and appear logical, observation of actual market behaviour suggests they don’t always hold. Many investors are aware of periods where the Australia 200 index has “climbed the wall of worry”. That is, despite obvious concerns about the outlook for shares the index has continued to rise.

Two factors that explain the “wall of worry” climb stand out – and they are both based on a behavioural understanding of markets. The first is around the way investors position themselves when fear rises. If the fear levels spike from a period of optimism they can spark significant selling, doing extensive damage to portfolios. Previously enthusiastic investors were wholly committed to the market (or possibly over extended) and are forced to sell, smashing the index.

However, where fears lift from already elevated levels the number of investors wholly committed to the market is much lower, and there may be little or no forced selling. In fact, if fear has persisted for an extended period, the index can continue to rise despite increasing concerns.

Secondly, investor fear is often stoked by those with no skin in the game. If you are directly involved in investing, the penalties for getting it wrong are financial. Get it badly wrong for an extended period and you’re out of the game.

Yet some participants in financial markets are wrong for very long periods without seeming to suffer any penalty. How can this be?

Academics have very little real exposure to financial markets. A certain professor has called for a housing market crash since 2008. Despite being completely wrong, he continues to do so. While his reputation may have suffered, he continues to hold academic posts, and appears to have suffered little personal damage. This contrasts with the experience of any housing market investors who’ve sold, or held off buying, a house on the back of the learned professor’s forecasts.

Similarly, some journalists are impervious to any consequences of inaccuracy – especially those employed by more established media outlets. A local senior economic writer has consistently called for a share market crash since at least 2012. The Australia 200 index briefly fell below 4,000 in that year, and is now more than 30% higher. Add in a dividend yield of around 7% a year (including franking) and any index investor who followed the calls of this guru missed around 60% in returns over the last four years.

In summary, those who help perpetuate a climate of worry often suffer little financial cost for being wrong. And when investors are already under exposed to the market, the share price index may rise despite a deteriorating environment. This explains not only why markets can climb the wall of worry, but why no rate cut today may also see stocks gain.

Through the ceiling

Perhaps even more supportive of higher shares is the price action. The daily chart of the Australia 200 index is above. The green lines define the trading range that persisted for the previous twelve months. There is no disputing that the index has broken out of the top of the range. While the future is always uncertain, this move suggests the risks are now on the upside.

Investors who committed on the break out are now well positioned to ride the market to a potential test of the resistance between 5685 and 5725 (tan lines). Market experts can be wrong, and no –one who attempts to forecast the future gets it 100% right. However, investors who ignored the urgings of experts like Peter “skin in the game” Switzer to gain share market exposures now have a dilemma on their hands.

The problem is that markets don’t often travel in a straight line. The rise from below 5200 to above 5600 is a steep one, and there will be a pull back at some stage. Under exposed investors can only hope for a pull back to the previous resistance, now support, at 5400. Unfortunately, hope is rarely a good investment strategy.

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